Principal Reduction: Is Debt Forgiveness Fair?

By Teke Wiggin

Few topics have sparked more debate among housing market watchers than mortgage principal reduction. Its proponents tout debt forgiveness as one of the surest ways to counteract the housing slump. Its critics label it a handout that would cost taxpayers and spur further defaults.

The arguments for and against are only going to get hotter. In 2010, principal reduction was included in just 11 percent of those mortgage modifications without government guarantees. But by the fourth quarter of 2011, the number had jumped to 40 percent, according to a report by mortgage research firm Amherst Securities Group. And it's likely to rise still further: The "robo-signing" settlement reached in February requires the country's five major mortgage servicers to perform at least $10 billion in write-downs, mostly on loans that they own, to atone for illegal foreclosures.

Now principal reduction is nipping at the heels of Fannie Mae and Freddie Mac. Many consumer advocates and policymakers are calling for the twin mortgage guarantors to adopt the loss-mitigation tactic, but so far the mortgage giants' conservator, the Federal Housing Finance Agency, has resisted.

Simmering beneath the surface of data-driven arguments both for and against principal reduction burns a more profound question, one that no doubt colors how most people view the proposed method:

Is principal reduction fair?

The question isn't just academic to borrowers like Doreen Thomas, a 78-year-old widow who has lived in her Maplewood, N.J., home since 1999.

Thomas receives $604 a month from Social Security, but with a $1,444 monthly mortgage payment, she's looking at eventual default. At this point, she has used up her savings and no longer can rely on assistance from her daughter, who has her own children to support.

Thomas has tried off-and-on for three years to acquire a loan modification. Recently, she said, Wells Fargo rejected her latest application.

"The little help I used to get, I don't know how much longer I will get it," Thomas said. "But then, something else might turn up. I do a lot of praying."

The Specter of 'Moral Hazard'

If she does stop paying her mortgage, she may then be eligible for principal reduction, which often requires that homeowners be in default to qualify. That raises the "moral hazard" objection: If Thomas stops paying, then other homeowners might do likewise in order to receive the same aid, said Mark Calabria, director of Financial Regulation Studies at the conservative Cato Institute.

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